A few weeks ago, This American Life aired an hour long story showing how the regulators at the Federal Reserve in New York were cozying up with Goldman Sachs, a member of the too-big-to-fail team that of course the Fed is supposed to oversee. For instance, thanks to some secret recordings, you can hear Fed officials talk about how they suspect a Goldman deal with Santander to be “legal but shady” . . . before shrugging the whole thing off. You can also hear both the regulators and Goldman executives acknowledge that the deal should have required Fed approval and then . . . see to no consequences for Goldman.

While this came as a shock to most people listening to the story, this behavior isn’t new. It’s called regulatory capture, and economists have known about it for over 40 years. I wrote about this in the Daily Beast last week:

No matter how infuriating this is, it is neither a unique case nor a new phenomenon. In fact, for over 40 years we have known that the romanticized “protection of the public” theory of regulation doesn’t hold water. And yet, it is still so prominent today.
In his seminal 1971 article, “The Theory of Economic Regulation,” (PDF) Chicago School economist George Stigler let America in on Washington’s dirty little secret: Regulations can be a capitalist’s best friend. He pointed out that industries with sufficient resources and political power have a huge incentive to exploit the state’s coercive power for their own ends. What might look like a regulation for the public interest from the outside is often little more than “regulatory capture” by corporate interests.

Last week, the New York Fed was in the news again for failing to do its job and appropriately supervise (whatever that really means) JP Morgan Chase. Ryan Tracy of the Wall Street Journal reported yesterday:

The Fed’s Office of Inspector General on Tuesday released a four-page summary of a year’s long investigation, saying Fed supervisors didn’t follow up on signs that the bank’s chief investment office—where the traders engaging in the problematic derivatives transactions were based—needed a closer look. A team of experts from across the Fed system recommended the New York Fed conduct “a full-scope examination” of the J.P. Morgan unit in 2009, but the regulator never did, the report said.
In 2012, J.P. Morgan announced losses in the unit related to botched derivatives trades that eventually cost the bank $6 billion.

According to the piece, experts from across the Federal Reserve recommended that the New York Fed conduct “a full-scope examination” of the JP Morgan unit in 2009, but it never did. Why shouldn’t this be surprising?

For one, the Fed has way too much on its plate — it’s monetary-policy meddler, lender of last resort, and bank regulator all at once – which means that it is unlikely to do any of its job well. Now add to this the political constraints and regulatory capture and you wonder how they get anything right ever. What’s happening on the bank side can only add to the confusion that already reigns: They have to put up with an array of regulatorsd at all times — the Fed, the FDIC, the CFPB, and the OCC – and even if they ignore some rules, they have got to spend a serious amount of time complying with most of them, rather than runing their business.

My question: To what extent did the existence and involvement of the regulators and the bank’s influence over them create disincentives for the company to behave in a way that’s not good for shareholders?

For instance, one would think that a for-profit bank would have a strong incentive, stronger than the regulators’ incentives, to prevent and avoid losses. Could it be that the hands-on regulators bring unnecessary confusion and a false sense of safety to some of these banks? In other words, if the regulators are overseeing the bank’s operations so closely but without imposing penalties, could it lead the bank to be less vigilant than it otherwise would be? (Regulation magazine had a good piece this summer showing how hurricane-zone building codes can make houses less safe than they would be without the codes).

Now add to this the fact that regulators drop the ball (as they inevitably will) and fail to see when the bank is engaging in dangerous behavior, or the fact that regulators are captured by the banks, and you get the possibility of billions of dollars’ being paid by taxpayers to bailout troubled financial institutions.

My colleague Hester Peirce had a piece this week talking about the impact that regulations can have on bank’s behaviors and cultures. She writes:

Bank regulators write the intricate rules with which firms must comply. Regulatory agencies engage in hands-on management of banks’ compliance through on-site supervision, threats of enforcement action, and granting or withholding privileges (such as approval of dividend payouts or mergers).
Regulators also influence compliance by directing firm decision-making in key areas from capital, to customer relationships, to compensation, to crisis management. As my colleague Stephen Miller points out, regulations help to dictate the type of assets that banks hold. And, as a supervisory order directing a bank to stop serving payday lenders (published this week in connection with a congressional inquiry) illustrates, bank regulators also weigh in on whether particular customer relationships are appropriate. In the last crisis, regulators influenced strategic decision-making by large financial institutions, in part through the use of government funds and guarantees.
Even the example of bank malfeasance that Mr. Dudley uses in his speech-the manipulation of the London Interbank Offered Rate (LIBOR)-reminds us of just how central a role regulators play in influencing banks’ compliance culture. Mr. Dudley longs for a world in which an employee who suggests manipulating LIBOR is met with a resounding “no way” and a referral to compliance. Yet, when a banker told one of the New York Fed’s employees in late 2007 that “LIBOR’s being set too low anyway,” her recorded response was not moral outrage, but an unfazed “Yeah.”

The bottom line is that no matter what the regulators’ good intentions are, we should always expect them to fail. This is why we should really consider biting the bullet and letting the discipline of the market regulate these too-big-to-fail institutions. It may be rocky for the shareholders who have to face the music when their banks make mistakes, but taxpayers will be better off.